What is Window Dressing?
‘Window dressing is the adaptation of the rules to present financial statements in a better light’. In this sense, it is the ability of the enterprise to make decisions which affect their apparent performance in their financial statements. Therefore, ‘window dressing is making a situation appear better than it actually is’.
Accounting information should be published by public limited companies as well as by private limited companies by following the rules laid down by the statute and professional bodies. Rules governing the form and content of accounts, the dates by which the accounts must be published, and how figures are to be presented within the accounts, etc., are notified from time to time by the statutory and professional bodies.
The rules and regulations prescribed by different governing bodies are so complex that there is always scope for interpreting them to the advantage of the manager or the management. Motivated by the ‘opportunity of interpretation’, the managers either on their own or being directed by the directors bend the rules or re-interpret the rules or ignore the rules to present a better picture through the financial statements.
The information provided based on such discretion (i.e., interpreting or misinterpreting the rules and regulations) ‘appears to be true but it is not true’. That means the enterprises are in a position to depict a rosy picture to the information users through window dressing.
Window Dressing, But Why?
To protect the enterprise from takeovers (this is normally done by revaluing the assets, especially brands). By revaluing assets at a higher value the enterprise’s assets position is boosted so that the intended buyer is discouraged to put forward the buying proposal.
- To improve share valuations by showing increased profits (say, profits arising from revaluation being treated as revenue). The managers show the public that their performance is good though, in reality, it is not so.
- To appease the shareholders by showing better profits and thereby encouraging them to approve the accounts without interrogative questions at the Annual General Meeting (i.e., to manage the meeting smoothly, where it would be difficult otherwise).
- To increase revenue from takeovers. Though this act is considered to be fraudulent, enterprises manage it by furnishing approvable statistics to justify the act.
- To win or to retain institutional investors’ support. This is achieved by the method of using creative accounting to disguise poor performance trends (creative accounting is practiced by inflating the profit figures or by manipulating the figures of assets and liabilities).
- To retain or gain lines of credit. Business creditors are encouraged by strong liquidity (in reality the liquidity is managed).
Common way of window Dressing
One of the simple methods of window dressing (without the use of creative accounting) may be through the presentation of statistics in a way that enhances performance. Presentation of a graph by using high base figure for the vertical axis the increase is exaggerated to give an impression of massive improvement, though in reality it is not so or presenting a favorable picture of performance by taking the example of efficient performance division and hiding the poor performance division.
Negative dimensions of window dressing
- Gain institutional support.
- Increase revenue from takeovers.
- Improve credit rating.
Positive dimensions of window dressing
- Protect from takeovers.
- Improve share valuations.
- Gain shareholder’s approval.
Methods of Window Dressing
The most simple and common way window dressing is practiced is through the presentation of statistics in a way that it enhances performance. For example, of the live units, two units of sales performance is extremely good. While presenting the data relating to performance, the bad ones arc overshadowed deliberately with good ones. This type of presentation ‘disguises’ performance in a number of ways:
- The use of a high base figure for the vertical axis exaggerates the increase. A quick glance gives the impression of a massive improvement in sales performance. However, in reality, sales has improved very marginally, say 5%.
- By highlighting the good performance of one division (one market) the enterprise hides the poor performance of other divisions (markets).
- The figures presented do not take into account the negative impact of inflation or they are not compared with the performance figures of the competitors.
Further, window dressing extends beyond simple presentation techniques. In this sense, the figures can be ‘massaged’, so that they can be misrepresented or window dressing may be done through ‘creative accounting’. Certain examples are cited here:
- Brands have become a great deal more valuable in recent times. Taking the advantage of this, many enterprises adjust the strength of their balance sheets by revaluing the brands (assets). Increase in brand valuation will increase the strength of the enterprise at least on paper. In most cases, increase in ‘brand value’ is recorded by revaluation procedure to defend takeovers. Suppose, the recorded value of the brand (asset) is $25 lakh and it is revalued at $50 lakh and shown in the balance sheet. The result is that the intended buyer thinks twice before negotiating for a takeover. It is the owner who knows the true value of the brand and not the intended buyer (outsider).
- By understanding the level of losses on assets, either profit can be increased or losses can be minimized. That means, window dressing is done, by hiding the cost of poor investments.
- The liquidity of the enterprise is improved by adopting a method of ‘Sale and Lease Back’. By selling large capital assets, cash flow is increased. By using the technique of leasing back the same asset (large capital asset sold) at a cost (which is chargeable to revenue) the revenue generation goes on unaffected and simultaneously huge funds are made available for developmental activities.
In recent times we observe that sale and leaseback is a normal business practice. Even this practice is adapted to improve the short-term cash situations and therefore, improve current asset ratio and liquidity. If this process is carried out for short-term liquidity reasons, questions should arise over long-term business performance. It should be noted that such a practice is neither illegal nor unethical and it is within the ambit of accounting practices as guided by the governing bodies.
- Window dressing is done by the use of exceptional and extraordinary terms. This is done by including the cost and revenues that arise from normal business activity but are unusual in some way. For example, redundancy costs are normal to business but they are exceptional items. Similarly, revenues that arise once in a way that is unusual and unlikely to be repeated. If such items are specifically shown as exceptional items, it is alright.
But, if they are shown as regular items, revenues are affected resulting in understating of profits (inclusive of redundancy cost) or oversetting of profits (inclusion of unusual revenue). As these items do not occur as a result of normal business activity, they should be highlighted and should be included only after calculating PBIT. If such items are included as normal items, it results in the regular profit being understated or overstated.
- Window dressing is done by choosing a convenient time of reporting. For example, the enterprise has been operating throughout the year with a negative bank balance. The manager does not wish to show this position in the balance sheet. As the financial statements are reviewed by many outsiders the manager postpones the payments to be made during the last week of the financial year close, so that the balance sheet can show a positive bank balance projecting a good liquidity position.
When these payments are made after the date of balance sheets, bank balance is bound to be negative. Such crucial information which is used for determining the liquidity of the enterprise is window dressed by choosing a convenient time of reporting.
- Choosing a convenient method of depreciation to depict a rosy picture. For example, by choosing fixed installment method of charging depreciation to reducing balance method, profits can be boosted.
- The residual values of the assets can be altered to window dress the balance sheet.
Therefore, there are number of ways in which financial statements are window dressed to present a rosy picture.
Window dressing done to serve the positive purpose, without violating the principles and standards of accounting is not considered as illegal. However, fraudulent practices indulged under the umbrella of window dressing are punishable under law.
All accounting professionals, analysts of accounts, rating agencies and other professional bodies are aware of this type of practice. Therefore, to have a true picture of the financial statements, the balance sheet and profit and loss account should be examined in detail, comparisons made against major competitors and indusüy standards.
The detailed examination relating to machinery and its depreciation should be held on these lines:
- What is the life span of the machine?
- How much did it cost originally?
- How much will it be worth at the end of its useful life (residual value)?
- What will be its value after one year, two years, three years, 15 years? And so on.
- Would anyone else want to buy it?
- How specialized is it?
- What would it cost to replace after 5 years? 8 years? etc.
- What is the method of depreciation in practice?
- Is the method equivocally applied without change?
- Is the method of depreciation changed any time? With what result? And how is it accounted for? etc.
- Window dressing is making a situation appear better than it actually is.
- Window dressing is done to protect from takeovers, to improve share valuations, to appease the shareholders with increased profits, to increase revenue from takeovers, to win or retain institutional investors support, to retain or gain lines of credit, etc.
- Presentation of statistics in a way, that enhances performance, is the most commonly used technique of window dressing.
- It has become a necessity or pressure to please shareholders.
- It is not illegal.
- Massaging of accounts is done by choosing the timing of reporting.
- Deliberate deception in the accounts is a fraud.
The following information is extracted from the books of Goodluck Company Ltd for the year 2019-20.
The company’s net profit before tax is during the year which is 20% less than the previous year. Disappointed with the operating performance, the manager decided to window dress the figures to boost the profits to give a picture to the shareholders that the operating efficiency is good. The following steps were taken to achieve this goal:
- Closing stock figures were inflated by 25%
- Repairs to building $100,000 should be capitalized
- To show investments at their present market value which is 15% above the cost
- Goodwill to be revalued and shown at $300,000
- Bad debts written off $50,000 to be treated as good debts
The balance sheet of the company before widow dressing stood as follows:
Note: Students should note that the above statement is prepared only to illustrate how window dressing helps to boost profits (on paper). They are all hidden adjustments which are known only to the accounts manager and to no one else. (They are not recorded at all.)
Note: The major drawback of this decision is the company will have to pay corporate tax on boosted profits (profits on paper). Supposing corporate tax is 30%, the tax to be paid now = $595,000 x 30% = $178,500. Tax to be paid on real profits (without window dressing) =$250,000 x 30% = $75,000. [(it should be noted that the company is paying extra tax to the tune of $103,500 ($178,500 – $75,000). In reality, the real profit is reduced to $146,500 ($250,000 – 103,500).]